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Earning on Conservation

An earnings-equivalence model helps utilities and regulators calculate appropriate returns for conservation investments.

Fortnightly Magazine - December 2007

associated with a $100 rate-based investment. Since the equivalent earnings are calculated for common equity only, the ratebase is multiplied by the weighted return on equity—5.24 percent. However, the utility must earn enough to pay the income taxes associated with the equity earnings to net 5.24 percent to the equity holder. Therefore, the before-tax weighted return on equity is used—8.85 percent.

The before-tax earnings results for the 12 years are then added to total $37. But these total returns must be discounted back to the present to calculate the total return amount anticipated from the $100 investment in current dollars. The discount rate used to move the dollars back through time is equal to the utility’s weighted average cost of capital—8.23 percent. This number is sometimes referred to as the discount rate. Its value is equal to the opportunity cost of money for the utility’s capital holders (see Table 3) .

In this example, the utility’s common stockholders would expect to earn, in today’s dollars, $26 per $100 invested, or 26 percent of the amount invested. This result is the earnings equivalency and is comparable to the rate (PER) in the energy-efficiency incentive mechanism.

This percentage applies to the net benefits of the energy-efficiency programs, not to the costs of those programs. Therefore, the utility has the incentive to get the most efficiency it can from the program budget.

Contract Effects

Some utilities rely on long-term power or natural gas contracts for all of their supply needs. When these contracts are present, a modified analysis might provide more desirable results. Specifically, the capital structure might change, because long-term energy contracts frequently are treated similarly to a long-term debt obligation when examining the financial risk of a utility. Generally accepted practices discount the amount of the energy contract to only a portion of its total value. A 20 to 30 percent discount is typical; for example, if the contract had a total value of $100, only $20 to $30 would be included in the capital structure (see Table 4) .

The contract payment is assumed to be $100 per year for 12 years. This payment is like an annual debt payment because it is a fixed financial commitment for the duration of the contract. The NPV of the 12-year contract is $745. The discount rate, as stated earlier, is the utility’s weighted average cost of capital, or 8.23 percent. The NPV of the remaining contract payments is calculated for each year and summed together in place of taking the NPV of the whole stream of payments. This is necessary in case additional contracts are added during the 12-year period.

In this analysis, since no additional contracts are added, the result would be the same if one simply took the NPV of the whole stream of payments. The discount rate is equal to the cost of debt, or 5.75 percent, pursuant to the methodology from Standard & Poor’s. The cost of debt is used as the discount rate because the contract is treated like debt for purposes of calculating the risk factor.

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